Published January 17-21, 2021
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Return on Capital: 10-20-30
As an entrepreneur who has been successful once, I am asked a question by many people – Why do I want to work hard again? Why go through all the ups and downs of running a business? Why not retire and enjoy life? Besides the answer that I do love running a business and that is life, there is another answer to these questions. Building and owning a successful business is the best path to wealth creation.
Let’s say you have some money. Where do you deploy it? One obvious answer is to invest it in the markets – maybe a mix of equity and debt. Since an entrepreneur is not necessarily an expert in investing, this will be done via portfolio managers or mutual funds. Long-term returns from such investments will be 10% per annum. Luck aside, it is hard to do passive investing that will give high returns.
One could then move to active investing – studying industries and stocks, and making long-term bets on specific companies. One could also invest in private companies – as an angel or via other venture capital funds. Given that this is likely to be in a basket of companies, some will succeed and others not. The ones which succeed will give very good returns. Long-term, one could perhaps hope for returns of about 20% per annum. Not easy but doable.
The third approach, which I favour, is to grow a proficorn. Once one has got past the initial stages of a business (where the mortality rate is highest), the odds of success improve dramatically with each passing year. Over a period of time, an entrepreneur should be able to deliver growth and returns of about 30% per annum. If dilution is limited, the upside is captured by the entrepreneur.
While a 10% difference may not seem much, apply the power of compounding over a decade and see the difference:
- 10% growth for 10 years will see Rs 100 become Rs 260 (2.6X)
- 20% growth for 10 years will see Rs 100 become Rs 650 (6.5X)
- 30% growth for 10 years will see Rs 100 become Rs 1,400 (14X)
For an entrepreneur, investing capital at 10% returns will yield less than a fifth of the returns than owning a successful and growing business growing at 30%. The decision to therefore keep running a proficorn is a no-brainer! Why would I sell (if I can see sustainable high future growth), convert it into cash and reduce my financial returns by 80%? A proficorn entrepreneur should therefore only sell if the prospects of growth diminish or the value paid by the buyer is extremely high.
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The Rule of 100
A few years ago, I came across the Rule of 40 – the principle that for a software company, it’s revenue growth rate and profit margin should exceed 40%. Here is what it means in practice:
- If a business is growing at 100%, it can have a profit margin of -60%
- If a business is growing at 60%, the profit margin can be -20%
- If a business is growing at 20%, the profit margin should be +20%
Bain has more on the Rule of 40:
The Rule of 40…has gained momentum as a high-level gauge of performance for software businesses in recent years, especially in the realms of venture capital and growth equity. Increasingly, software industry executives are embracing the Rule of 40 as an important metric to help measure the trade-offs of balancing growth and profitability.
Software companies that can balance growth and profitability to outperform the Rule of 40 have valuations (measured by the ratio of enterprise value to revenue) double that of companies that fall “below the line,” and they achieve returns as much as 15% higher than the S&P 500. Companies whose growth slows and that fail to improve profitability often find themselves the target of activist investors and private equity acquirers.
I was thinking recently about proficorns, the profits generated and the trade-offs between profits and growth. What is a good-sized proficorn? Since proficorns do not have external investors, there is no benchmark valuation being set. How can proficorn entrepreneur’s benchmark themselves?
While my approach is not scientific or backed up by a study of proficorns, I came up with two key metrics:
- Profits (EBIDTA): this is important because it can measure the cash being generated each year. Profits are the oxygen for a proficorn’s growth, since there is no external capital. Profits help the entrepreneur invest in new areas, expand geographies or even acquire other businesses. Profit after tax (PAT) can have many other accounting elements factored in, so EBIDTA is a better metric to use. For our purposes, we can measure EBIDTA in millions of dollars. If the entrepreneur chooses, one-off investments / gains / write-offs can be excluded from this number.
- EBIDTA Growth percentage: Stagnation can be the death knell for a business. So, growth is important, especially in tech. Measuring growth in EBIDTA gives a glimpse into the future health of the business.
So, take these two numbers (EBIDTA in millions of dollars and EBIDTA percentage growth) and multiply them. The first goal for an entrepreneur should be to get the result to be more than 100 – for the business to have a healthy valuation (let’s say, $100 million or more). Thus, if a business is generating $5 million EBIDTA, it must have a growth rate of 20% or more to get a valuation of $100 million or more. If the business is generating $10 million in EBIDTA, growth can be lower at 10% to achieve the same benchmark valuation.
Admittedly, this is not backed by deep analysis – it is just a simple rule of 100 to guide entrepreneurs towards the magic marker of crossing $100 million in valuation. In today’s world, growth is being valued even more highly. But in my thinking, growth cannot come at the cost of profits. The Rule of 100 can help proficorn entrepreneurs balance the two – ensure the right mix of cash generation to invest in the future, and maintain a steady growth trajectory.
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Where to Invest
Bijal, a colleague at Netcore, pointed me to a question asked on Twitter by Paras Chopra (founder of Wingify): “If you were the founder of a bootstrapped company with enough money to invest into business, how would you invest it such that your VC funded competitors will not be able to do replicate?” Bijal wanted to know my views on the question.
My initial reaction was: “Business is not like physics or maths! Answers differ for everyone, and every business. Every company has to make its own choice. Some can invest in new experiments, some in buyback, some in acquisitions… And at times you have to just save for a rainy day also — like a Covid-type situation.” And as Paras clarified: “The point is to do something different that turns out to be valuable.”
I then read some of the replies on the Tweet thread:
- There isn’t that much difference between money, but I guess one big difference is that bootstrapped companies can diversify more? VC money is typically used to double down on what you already have.
- This means the investment will have to be something VCs would never sign off on. Maybe a second profit center, or a community
- Be insanely patient and think in years/decades and not days/weeks/months. Most VC funded competitors are not encouraged nor incentivized to think in years.
- Invest in things that money cannot quickly scale. Like a good SEO based strategy. A good white hat campaign cannot be replicated with VC money, while Ads can scale, Sales can be scaled. Eg: Canva, Freshbooks
- Investing in experiments in markets where there is no consensus about “massiveness of the market”. Ex – 40+ internet users in India, teens in India, pet owners in India, home gardening in India etc. VC’s never invest without conviction on market size.
- Find the right people for the right Hard to compete in Money, but can make a difference in choosing people.
- I wouldn’t worry about VC funded competitors. I would focus on the founders, their vision, the problem and the market and will decide based on that and will try to help the founders to succeed.
- Sharp focus on capital allocation…and hence prioritise on what enhances the moat around your business. Capital allocation is a skill that founders of bootstrapped companies need to acquire/get help with vs VC funded competition.
- Do things where capital isn’t the primary moat / irrespective of capital that aspect takes time to build. Some egs : in B2C -> SEO, in B2B -> strong founder level relationships with the largest clients (assuming capital = strong tech)
- Chase profits and growth at the same time, not just growth singularly. That’s a lot more valuable than just burning truckloads of cash and then raising more and more to sustain/further grow the biz
- Invest in companies in adjacent domains which help you create a MOAT to keep and protect your business forever.
Interesting answers. As I thought more about the question, I came to another conclusion. In today’s world, growth and scale are both important. A single company cannot solve every problem. There will always be startups doing interesting things faster than a larger company can. What a profitable company can do is to do an IPO and get listed on the exchanges – because this does two things. First, it provides currency for acquisitions. Second, it provides liquidity to employees. Both are critical for the proficorn to maintain an edge. Private companies end up having to pay in cash for acquisitions if no benchmark valuation has been set.
So, as a bootstrapped company, the aim should be to achieve scale to do a listing which then provides the capital and currency for accelerating growth via acquisitions (and also bringing on more talent). There will always be many startups (VC-funded or bootstrapped) who will be looking for an exit. Acquiring and integrating them rapidly can provide a powerful playbook for even more profitable growth.
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Mountains beyond Mountains
This is a phrase I use often in conversations to describe the series of challenges an entrepreneur faces when building a business. I first came across this phrase many years ago. It was the title of a book by Tracy Kidder on the life of Paul Farmer. One of Tracy Kidder’s previous books, “The Soul of a New Machine”, had won a Pulitzer Prize. The book, published in 1981, told the story of a team at Data General that was building a next-generation computer. “Mountains beyond Mountains” was published in 2003. It chronicles the life of Farmer, who was fighting tuberculosis in Haiti and other countries. The title comes from a Haitian proverb: “Beyond mountains, there are mountains.” It means that as you solve one problem, another will present itself.
From an enotes answer on the book’s title: “The mountains could metaphorically represent obstacles, and this proverb could be read in a negative way to mean that there are always more obstacles in your way. However, it’s also possible to read the proverb in a more positive light if we interpret the mountains to metaphorically represent opportunities. A mountain, after all, represents an opportunity for self-betterment and an opportunity to achieve something significant by reaching the summit. Reaching the summit, or overcoming the problem, is a cause for celebration.” Another answer adds: “The proverb gives us the sense that as soon as an obstacle is overcome or a problem is solved, another one is waiting.”
The life of an entrepreneur is very much that of climbing one mountain only to see another higher one waiting. The second mountain was perhaps obscured by the mountain in the front, so it only comes into sight after the first has been climbed. And so it goes. One problem after another, one challenge after another. Day after day.
Building a business is not like walking down a straight road. Climbing a mountain requires courage, determination and stamina – and some luck. One misstep and the consequences could be disastrous – getting lost, a fall, or even death (failure). The journey is never finished – because once one problem has been solved, another one awaits to be tackled.
So, why do entrepreneurs do it? Why do they stake it all for the hard life? For the entrepreneur, it is not always about money. Of course, the financial rewards are an important motivator. But there is much more. Just like Paul Farmer dedicated his life to conquering disease and making the world a better place, so too does the entrepreneur – risking everything to improve something seen as inefficient. It is this belief that things can be made better that provides the energy to wake up every morning and climb higher, fall a little, and start all over again. And once one peak has been reached, it is onward to the next one. Mountains beyond Mountains.
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When Things Go Wrong
Things will go wrong. Mistakes happen. Some are small and can be fixed easily; others are serious ones and cause trouble to customers and therefore need to be addressed proactively. And every so often something happens that shakes the very foundation of the business – a life-or-death moment. Those are the ones which keep the entrepreneur always on the edge. If not tackled right, such unanticipated events can lead to setbacks which are hard to recover from.
In my entrepreneurial life spanning almost three decades, I have had many such ‘death knell’ moments. It could be a critical employee leaving, the loss of a key customer, a competitor launching a faster-better-cheaper alternative, an algorithm change done by Google which changes the game completely, a government diktat that upends the state of play, a data hack that leaks sensitive customer information, or a software error that causes a system crash leading to downtime for mission critical operations. In recent times, it was the zero-revenue nightmare caused by the onset of lockdowns after Covid-19 hit. The question in all cases for an entrepreneur is one of business survival.
When many years ago, TRAI jacked up SMS prices by a factor of 10, I was faced with such a life-and-death moment for MyToday. There was no way we could absorb an overnight increase of 10X in the costs of sending SMSes, and so I had no choice but to kill the service. I had not anticipated such TRAI action. If I had, perhaps I could have switched from SMS to email as a mode of communication. In the midst of the war, I did not think clearly and thought that that was nothing possible.
When Covid-19 started spreading in March, I worried about what actions the government would take. I told our HR department to start planning for employees to work from home. That early action gave us a week’s lead time before the harsh lockdown was announced. That week made all the difference – it allowed us to get laptops for people, get key teams acclimatised to working from home, and gave us early learnings on how to make the transition. Had we not planned, the business impact would have been very severe for many individuals and teams, and therefore for our customers.
It is the rare business that does not suffer setbacks. As an entrepreneur, it is important to make a list of things that can go wrong. This needs to be done when things are going well – what I call ‘peacetime.’ During those times, it is possible to think with a calm mind and work out possible actions. When the problem happens, it is ‘war time’ and because the entrepreneur is in the midst of battle, there is a fog which can cloud one’s thinking. Of course, not every eventuality can be thought through, but the more that can, the better one can plan. The focus should be on extreme events. Ask a single question: What can happen to kill the business overnight? List all such things, and what possible steps can be taken to forestall such actions or reduce the fatality from such an action. Thinking through this will let you create the airbags which can help you survive.
The same principle also applies to life. Excluding death (in which case one cannot do anything), can you plan better for extreme eventualities – the ‘Black Swan’ moments in our life? Spend a few hours thinking about this. The hope of course is that none of it will happen, but if anything does, you (and those around you) will be better prepared.